“It also confirms the early warning over weakening end-user demand given by developments in the global chemical industry since the start of the year. Capacity Utilisation was down again in September as end-user demand slowed. And this pattern has continued into early November, as shown by our own Volume Proxy.”

The same phenomenon had occurred before the 2008 Crisis, of course, as described in The Crystal Blog. I wrote regularly here, in the Financial Times and elsewhere about the near-certainty that we were heading for a major financial crisis. Yet very few people took any notice.

So why did Apple shares suddenly crash 10% on 3 January, as the chart shows? Everything that Apple reported was already known. After all, when I wrote in November, I was using published data from Strategy Analytics which was available to anyone on their website.

The answer, unfortunately, is that markets have lost their key role of price discovery. Central banks have deliberately destroyed it with their stimulus programmes, in the belief that a strong stock market will lead to a strong economy. And this has been going on for a long time, as newly released Federal Reserve minutes confirmed last week:

The result is that few investors now bother to analyse what is happening in the real world.

They believe they don’t need to, as the Fed will always be there, watching their backs. So “Bad News is Good News”, because it means the Fed and other Western central banks will immediately print more money to support stock markets.

And there is even a new concept, ‘Modern Monetary Theory’ (MMT), to justify what they are doing.

THE MAGIC MONEY TREE PROVIDES ALL THE MONEY WE NEED

There are 3 key points that are relevant to the Modern Monetary Theory:

The Federal government can print its own money, and does this all the time

The Federal government can always roll over the debt that this money-printing creates

The Federal government can’t ever go bankrupt, because of the above 2 points

The scholars only differ on one point. One set believes that pumping up the stock market is therefore a legitimate role for the central bank. As then Fed Chairman Ben Bernanke argued in November 2010:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

“MMT logically argues as a consequence that there is no such thing as tax and spend when considering the activity of the government in the economy; there can only be spend and tax.”

The result is that almost nobody talks about debt any more, and the need to repay it. Whenever I talk about this, I am told – as in 2006-8 – that “I don’t understand”. This may be true. But it may instead be true that, as I noted last month:

“Whilst Apple won’t go bankrupt any time soon, weaker companies in its supply chain certainly face this risk – as do other companies dependent on sales in China. And as their sales volumes and profits start to fall, investors similarly risk finding that large numbers of companies with “Triple B” ratings have suddenly been re-rated as “Junk”:

Bianco Research suggest that 14% of companies in the S&P 1500 are zombies, with their earnings unable to cover interest expenses

The Bank of International Settlements has already warned that Western central banks stimulus lending means that >10% of US/EU firms currently “rely on rolling over loans as their interest bill exceeds their EBIT. They are most likely to fail as liquidity starts to dry up”.

I fear the coming global recession will expose the wishful thinking behind the magic of the central banks’ money trees.

The central banks’ aim was set out in November 2010 by US Federal Reserve Chairman, Ben Bernanke:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

And the current Chairman, Jay Powell, rushed to calm investors on Friday by confirming this policy:

“We will be prepared to adjust policy quickly and flexibly and use all of our tools to support the economy should that be appropriate.”

His words confirm he equates “the economy” with the stock market, as the chart shows:

The Fed no longer sees its core mandate on jobs and prices as defining its role

Instead it has become focused on making sure the S&P 500 moves steadily upwards

Every time the S&P 500t flirts with breaking the lower “tramline”, the Fed rushes to its rescue

Like Wile E Coyote in the Road Runner cartoons, the Fed has used more and more absurdly complex strategies to try and keep the market going upwards. But now it is very close to finding itself over the cliff edge.

CORPORATE DEBT IS THE KEY RISK FOR 2019

The Fed should have realised long ago that markets cannot keep climbing forever. Instead, by printing $4tn of free cash, it has temporarily destroyed their key role of price discovery. As a result:

Investors now have no idea if are paying too much for their purchases

Companies don’t know if their new investments will actually make money

We are heading almost inevitably to another ‘Minsky Moment’ as I described in September 2008,:

“Earnings from the new investments prove too low to pay the interest due on the debt. Confidence in the ‘new paradigm’ disappears and, with it, market liquidity. Investors find themselves unable to sell the under-performing asset, and suddenly realise they have over-paid. In turn, this prompts a rush for the exits. Prices then begin to drop quite sharply, as ‘distress sales’ take place.”

This time, however, the risk is in corporate debt, not US subprime lending. As the charts above show:

The ratio of US corporate debt to GDP has reached an eye-watering 46%, higher than ever before

Lending standards have collapsed with most investment debt in the lowest “Triple B” grade

Investors’ obviously loved Powell’s confirmation on Friday that he is determined to cover their backs. But they may start to remember over the weekend that the cause of Thursday’s collapse was Apple’s problems in China – about which, the Fed can actually do very little.

And whilst Apple won’t go bankrupt any time soon, weaker companies in its supply chain certainly face this risk – as do other companies dependent on sales in China. And as their sales volumes and profits start to fall, investors similarly risk finding that large numbers of companies with “Triple B” ratings have suddenly been re-rated as “Junk”:

The Bank of International Settlements has already warned that Western central banks stimulus lending means that >10% of US/EU firms currently “rely on rolling over loans as their interest bill exceeds their EBIT. They are most likely to fail as liquidity starts to dry up”.

CHINA’S CORPORATE DEBT IS THE EPICENTRE OF THE RISK

As the chart shows, China’s corporate debt is now the highest in the world. Yet it hardly existed before 2008, when China’s leadership panicked and began the largest stimulus programme in history.

The “good news” is that China’s new leadership recognise the problem, as I discussed in November 2017, China’s central bank governor warns of ‘Minsky Moment’ risk. The “bad news” – for the Fed’s desire to support the stock market, and for companies dependent on Chinese demand – is that they are determined to tackle the risk, having warned:

“China’s financial sector is and will be in a period with high risks that are easily triggered. Under pressure from multiple factors at home and abroad, the risks are multiple, broad, hidden, complex, sudden, contagious, and hazardous. The structural unbalance is salient; law-breaking and disorders are rampant; latent risks are accumulating; [and the financial system’s] vulnerability is obviously increasing.”

Companies and investors need to take great care in 2019. China’s downturn means that markets are starting to rediscover their role of price discovery, despite the Fed’s efforts to keep waving its magic wand:

Companies with too much debt will go bankrupt, leading to the Minsky Moment

The domino effect of price wars and lower volumes will quickly hit other supply chains

Time spent today in understanding this risk will prove time very well spent later this year

Once the tramline is broken, the Fed and the S&P 500 will find themselves in Wile E Coyote’s position in the famous Road Runner cartoons – with nowhere to go, but down.

Last year it was Bitcoin, in 2016 it was the near-doubling in US 10-year interest rates, and in 2015 was the oil price fall. This year, once again, there is really only one candidate for ‘Chart of the Year’ – it has to be the collapse of China’s shadow banking bubble:

It averaged around $20bn/month in 2008, a minor addition to official lending

But then it took off as China’s leaders panicked after the 2008 Crisis

By 2010, it had shot up to average $80bn/month, and nearly doubled to $140bn in 2013

President Xi then took office and the bubble stopped expanding

But with Premier Li still running a Populist economic policy, it was at $80bn again in 2017

At that point, Xi took charge of economic policy, and slammed on the brakes. November’s data shows it averaging just $20bn again.

The impact on the global economy has already been immense, and will likely be even greater in 2019 due to cumulative effects. As we noted in this month’s pH Report:

“Xi no longer wants China to be the manufacturing Capital of the world. Instead his China Dream is based on the country becoming a more service-led economy based on the mobile internet. He clearly has his sights on the longer-term and therefore needs to take the pain of restructuring today.

“Financial deleveraging has been a key policy, with shadow bank lending seeing a $609bn reduction YTD November, and Total Social Financing down by $257bn. The size of these reductions has reverberated around Emerging Markets and more recently the West:

The housing sector has nose-dived, with China Daily reporting that more than 60% of transactions in Tier 1 and 2 cities saw price drops in the normally peak buying month of October, with Beijing prices for existing homes down 20% in 2018

It also reported last week under the heading ’Property firms face funding crunch’ that “housing developers are under great capital pressure at the moment”

China’s auto sales, the key to global market growth since 2009, fell 14% in November and are on course for their first annual fall since 1990

The deleveraging not only reduced import demand for commodities, but also Chinese citizens’ ability to move money offshore into previous property hotspots

Real estate agents in prime London, New York and other areas have seen a collapse in offshore buying from Hong Kong and China, with one telling the South China Morning Post that “basically all Chinese investors have disappeared “

GLOBAL STOCK MARKETS ARE NOW FEELING THE PAIN

As I warned here in June (Financial markets party as global trade wars begin), the global stock market bubble is also now deflating – as the chart shows of the US S&P 500. It has been powered by central bank’s stimulus policies, as they came to believe their role was no longer just to manage inflation.

Instead, they have followed the path set out by then Federal Reserve Chairman, Ben Bernanke, in November 2010, believing that:

“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

Now, however, we are coming close to the to the point when it becomes obvious that the Fed cannot possibly control the economic fortunes of 325m Americans. Common sense tells us that demographics, not monetary policy, drive demand. Unfortunately, vast amounts of time and money have been wasted by central banks in this failed experiment.

The path back to fiscal sanity will be very hard, due to the debt that has been built up by the stimulus policies. The impartial Congressional Budget Office expects US government debt to rise to $1tn.

Japan – the world’s 3rd largest economy – is the Case Study for the problems likely ahead:

China’s removal of stimulus is being matched by other central banks, who have finally reached the limits of what is possible

As the chart shows, the end of stimulus has caused China’s Producer Price Inflation to collapse from 7.8% in February 2017

Analysts Haitong Securities forecast that it will “drop to zero in December and fall further into negative territory in 2019“

China’s stimulus programme was the key driver for the global economy after 2008. Its decision to withdraw stimulus – confirmed by the collapse now underway in housing and auto sales – is already putting pressure on global asset and financial markets:

China’s lending bubble helped destroy market’s role of price discovery based on supply/demand

Now the bubble has ended, price discovery – and hence deflation – may now be about to return

Yet combating deflation was supposed to be the prime purpose of Western central bank stimulus

This is why the collapse in China’s shadow lending is my Chart of the Year.

Every New Year starts with optimism about the global economy. But as Stanley Fischer, then vice chair of the US Federal Reserve, noted back in August 2014:

“Year after year we have had to explain from mid-year on why the global growth rate has been lower than predicted as little as two quarters back.”

Will 2018 be any different? Once again, the IMF and other forecasters have been lining up to tell us the long-awaited “synchronised global recovery” is now underway. But at the same, they say they are puzzled that the US$ is so weak. As the Financial Times headline asked:

“Has the US dollar stopped making sense?”

If the global economy was really getting stronger, then the US$ would normally be rising, not falling. So could it be that the economy is not, actually, seeing the promised recovery?

OIL/COMMODITY PRICE INVENTORY BUILD HAS FOOLED THE EXPERTS, AGAIN
It isn’t hard to discover why the experts have been fooled. Since June, we have been seeing the usual rise in “apparent demand” that always accompanies major commodity price rises. Oil, after all, has already risen by 60%.

Contrary to economic theory, companies down the value chains always build inventory in advance of potential price rises. Typically, this adds about 10% to real demand, equal to an extra month in the year. Then, when the rally ends, companies destock again and “apparent demand” weakens again.

The two charts above confirm that the rally had nothing to do with a rise in “real demand”:

Oil prices have risen 60% since June, from $44/bbl to $71/bbl on Friday

Their buying has powered the rise in oil prices, based on the free cash being handed out by the central banks, particularly in Europe and Japan, as part of their stimulus programmes.

They weren’t only buying oil, of course. Most major commodities have also rallied. Oil was particularly dramatic, however, as the funds had held record short positions till June. Once they began to bet on a rally instead, prices had nowhere to go but up. 1.4bn barrels represents as astonishing 15 days of global oil demand, after all.

What has this to do with the US$, you might ask? The answer is simply that hedge funds, as the name implies, like to go long in one market whilst going short on another. And one of their favourite trades is going long (or short) on oil and commodities, whilst doing the opposite on the US$:

The chart highlights the result, showing how the US$’s fall began just as oil/commodity prices began to rise.

COMPANIES HAVE NO CHOICE BUT TO BUILD INVENTORY WHEN COMMODITY PRICES RISE
This pattern has been going on for a long time. But I have met very few economists or central bankers who recognise it. They instead argue that markets are always efficient, as one professor told me recently:

“Economists would tend to be skeptical about concepts such as “apparent demand”. Unless this a secret concept (and it doesn’t seem like it is), other investors should also use it, and then the oil price should already reflect it. Thus, there wouldn’t be gains to be made (unless you’re quicker than everyone else or have inside information)…”

But if you were a purchasing manager in the real world, you wouldn’t be sceptical at all. You would see prices rising for your key raw materials, and you would ask your CFO for some extra cash to build more inventory. You would know that a rising oil, or iron, or other commodity price will soon push up the prices for your products.

And your CFO would agree, as would the CFOs of all the companies that you supply down the value chain.

So for the last 6 months, everyone who buys oil or other commodity-related products has been busy building as much inventory as they could afford. In turn, of course, this has made it appear that demand has suddenly begun to recover. At last, it seems, the “synchronised global recovery” has arrived.

Except, of course, that it hasn’t. The hedge funds didn’t buy 15 days-worth of oil to use it. They bought it to speculate, with the OPEC-Russia deal providing the essential “story” to support their buying binge.

THE RISE IN COMMODITY PRICES, AND “APPARENT DEMAND”, IS LIKELY COMING TO AN END
What happens next is, of course, the critical issue. As we suggested in this month’s pH Report:

“This phenomenon of customers buying forward in advance of oil-price rises goes back to the first Arab Oil Crisis in 1973 – 1974. And yet every time it happens, the industry persuades itself “this time is different”, and that consumers are indeed simply buying to fill real demand. With Brent prices having nearly reached our $75/bbl target, we fear reality will dawn once again when prices stop rising.”

Forecasting, as the humorist Mark Twain noted, “is difficult, particularly about the future”. But hedge funds aren’t known for being long-term players. And with refinery maintenance season coming up in March, when oil demand takes a seasonal dip, it would be no surprise if they start to sell off some of their 1.4bn barrels.

No doubt many will also go short again, whilst going long the US$, as they did up to June.

In turn, “apparent demand” will then go into a decline as companies destock all down the value chain, and the US$ will rally again. By Q3, current optimism over the “synchronised global recovery” will have disappeared. And Stanley Fischer’s insight will have been proved right, once again.

Global interest rates have fallen dramatically over the past 25 years, as the chart shows for government 10-year bonds:

 UK rates peaked at 9% in 1995 and are now down at 1%: US rates peaked at 8% and are now at 2%
 German rates peaked at 8% and are now down to 0%: Japanese rates peaked at 4% and are now also at 0%

But what goes down can also rise again. And one of the most reliable ways of investing is to assume that prices will normally revert to their mean, or average.

If this happens, rates have a long way to rise. Long-term UK interest rates since 1703 have averaged 4.5% through wars, booms and depressions. If we just look more recently, average UK 10-year rates over the past 25 years were 4.6%. We are clearly a very long way away from these levels today.

This doesn’t of course mean that rates will suddenly return to these levels overnight. But there are now clear warning signs that rates are likely to rise as central banks wind down their Quantitative Easing (QE) and Zero Interest Rate stimulus policies. The problem is the legacy these policies leave behind, as the Financial Times noted recently:

“In total, the six central banks that have embarked on quantitative easing over the past decade — the US Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England, along with the Swiss and Swedish central banks — now hold more than $15tn of assets, according to analysis by the FT of IMF and central bank figures, more than four times the pre-crisis level.

“Of this, more than $9tn is government bonds — one dollar in every five of the $46tn total outstanding debt owed by their governments. The ECB’s total balance sheet recently topped that of the Fed in dollar terms. It now holds $4.9tn of assets, including nearly $2tn in eurozone government bonds.”

The key question is therefore ‘what happens next’? Will pension funds and other buyers step in to buy the same amount of bonds at the same price each month?

The answer is almost certainly no. Pension funds are focused on paying pensions, not on supporting the national economy. And higher rates would really help them to reduce their current deficits. The current funding level for the top US S&P 1500 companies is just 82%, versus 97% in 2011. They really need bond prices to fall (bond prices move inversely to yields), and rates to rise back towards their average, in order to reduce their liabilities.

The problem is that rising yields would also pressure share prices both directly and indirectly:

 Some central banks have been major buyers of shares via Exchange Traded Funds (ETFs) – the Bank of Japan now owns 71% of all shares in Japan-listed ETFs
 Lower interest rates also helped to support share prices indirectly, as investors were able to borrow more cheaply

Margin debt on the New York Stock Exchange (money borrowed to invest in shares) is now at an all time high in $2017. Ominously, company buy-backs of their shares have already begun to slow and are down $100bn in the past year.

House prices are also in the line of fire, as the second chart shows for London. They have typically traded on the basis of their ratio to earnings

 The average ratio was 4.8x between 1971 – 1999
 But this ratio has more than doubled to 12x since 2000 as prices rose exponentially during subprime and then QE

The reason was that after the dotcom crash in 2000, the Bank of England deliberately allowed prices to move out of line with earnings. As its Governor, Eddie George, later told the UK Parliament in March 2007:

“When we were in an environment of global economic weakness at the beginning of the decade, it meant that external demand was declining… One had only two alternatives in sustaining demand and keeping the economy moving forward: one was public spending and the other was consumption….

“We knew that we had pushed consumption up to levels that could not possibly be sustained in the medium and longer term. But for the time being if we had not done that the UK economy would have gone into recession, just like the economies of the United States, Germany and other major industrial countries. That pushed up house prices and increased household debt. That problem has been a legacy to my successors; they have to sort it out.”

Of course, as the chart shows, George’s successors did the very opposite. Ignoring the fact that a bubble was already underway, they instead reduced interest rates to near-zero after the subprime crisis of 2008, and flooded the market with liquidity. Naturally enough, prices then took off into the stratosphere.

Today, however, the Bank is finally recognising – too late – that it has created a bubble of historical proportions, and is desperately trying to shift the blame to someone else. Thus Governor Mark Carney warned last week:

“What we’re worried about is a pocket of risk – a risk in consumer debt, credit card debt, debt for cars, personal loans.”

Of course, the biggest “pocket of risk” is in the housing market:

 Lower interest rates meant lower monthly mortgage payments, creating the illusion that high prices were affordable
 But higher prices still have to be paid back at the end of the mortgage – very difficult, when wages aren’t also rising

The Bank has therefore now imposed major new restrictions on lenders. They have ordered them to keep new loans at no more than 4.5x incomes for the vast majority of their borrowers. And lenders themselves are also starting to get worried as the average deposit is now close to £100k ($135k).

Of course, London prices might stay high despite these new restrictions. Anything is possible.

But fears over a hard Brexit have already led many banks, insurance companies and lawyers to start moving highly-paid people out of London, as the City risks losing its “passport” to service EU27 clients. Over 50% of surveyors report that London house prices are now falling, just as a glut of new homes comes to market. In the past month, asking prices have fallen by £300k in Kensington/Chelsea, and by £75k in Camden, as buyers disappear.

The next question is how low could prices go if they return to the mean? If London price/earning ratios fell back from today’s 12x ratio to the post-2000 average of 8.2x level, average prices would fall by nearly a third to £332k. If ratios returned to the pre-2000 level of 4.8x earnings, then prices would fall by 60% to £195k.

Most Britons now expect a price crash within 5 years, and a quarter expect it by 2019. Brexit uncertainty, record high prices and vast overs-supply of new properties could be a toxic combination, perhaps even taking ratios below their average for a while – as happened in the early 1990s slump. As then, a crash might also take years to unwind, making life very difficult even for those who did not purchase when prices were at their peak.

The Financial Times has kindly printed my letter below, wondering why the US Federal Reserve still fails to appreciate the impact of the ageing BabyBoomers on the economy

Sir, It was surprising to read that the US Federal Reserve is still puzzled by today’s persistently low levels of inflation, given that the impact of the ageing baby boomers on the economy is now becoming well understood (“An inflation enigma”, Big Read, September 19).

As the article notes, factors such as globalisation and technological advances have all helped to moderate price increases for more than two decades. But the real paradigm shift began in 2001, when the oldest boomers began to join the lower-spending, lower-earning over-55 generation. As the excellent Consumer Expenditure Survey from the Bureau of Labor Statistics (BLS) confirms, Americans’ household spending is dominated by people in the wealth creating 25-54 age cohort. Spending then begins to decline quite dramatically, with latest data showing a near 50 per cent fall from peak levels after the age of 74.

This decline was less important when the boomers were all in the younger cohort. BLS data show it contained 65m households in 2000, with only 36m in the older cohort. But today, lower fertility rates have effectively capped the younger generation at 66m, while the size of the boomer generation, combined with their increased life expectancy, means there are now 56m older households.

Consumer spending is around 70 per cent of the US economy. Thus the post-2001 period has inevitably seen a major shift in supply/demand balances and therefore the inflation outlook. So it is disappointing that the Fed has failed to go up the learning curve in this area. Demographics are not the only factor driving today’s New Normal economy, but central bankers should surely have led the way in recognising their impact.